Certificate of Deposits (CD) usually become a popular choice whenever stocks are in a bear market as people start to realize just how much portfolio values can fall. Put simply, a CD represent a deposit with the bank where the terms (length, interest etc) are pre-negotiated.
This is good because:
- the bank can rely on having that cash available
- you can count on the interest rate usually being fixed and is often higher than a regular savings account
Having said that, you do have the option to take money out of the CD before it’s term expires (the maturity date). It might come with stiff penalties as banks were counting on that money being held with them, but hey, if you need it, you need it!
Many regard certificate of deposits (CDs) as the least risky investment option. Add to the fact that the FDIC has recently increased the deposit guarantee to $250,000 per person (expires Jan, 2010) and you have an investment where the risk to principal is at a minimal.
Pitfalls of CDs
When I say minimal, it doesn’t equal “no risk”. Here are some areas you should look at when deciding on a CD:
Early Withdrawal Penalties
As metioned already, withdrawing before the maturity date usually comes with penalties. In most cases, this just means giving up interests but be careful here as sometimes you have to give up interests that you haven’t even earned yet!
Since there is no maximum rule for early withdrawal penalties, banks are free to do what they please. Imagine that you have a 2 year CD in which the withdrawal penalty is 6 months of interest. This means you will owe 2 months of interest if you withdraw on the 4th month!
To make matters worst, some CDs don’t even have to put in the exact penalty when you sign up for the CD! Read the fine print!
The $250,000 guarantee from FDIC will drop back down to $100,000 by January 1, 2010! This means that starting in 2010, any deposit over $100k can be lost if the bank that the CD is with fails. Therefore, be careful if you are thinking of making a CD with more than $100k that matures in 2010 or beyond.
Rates Can Change
Make sure you understand the disclosure document to read the details on the interest rate of the CD. Some CDs have fixed rates, while others have variable rates that range from a pre-defined step to ones where the rate is tied to the stock market!
Know the Calculation
Common assumption for CDs is that interests are calculated the day the desposit starts but some CDs can start calculating interests on the start of the next month or even when a new quarter starts! Make sure you know the details when you compare the different offerings from different banks!
Some CDs Allow the Bank to “Call” it Back
Certain CDs have a “call” feature that allow the bank to terminate the CD after a fixed time period. Furthermore, only the bank is allowed to call the CD back, not the depositor. Sure, the bank will give you all the interest up to the time when they call the CD back, but chances are they are doing this because the interests rate have fallen significantly! Once you get your money back, where are you going to put that cash? Therefore, if all else is equal, pick a CD without a “call” feature!
Be Absolutely Clear About the Maturity Date
Due to confusing advertising, many people mix up the callable date with the maturity date. For example, languages such as “six month non-callable CD” might be used to give you the impression that this is the CD matures in 6 months when what it really means is that the call feature isn’t in effect until 6 months after the start of the term! It would really be disasterous if you invest in that CD and it turns out that the maturity date is in 20 years!
Many CDs have auto renews for you unless you explicitly tell them to desposit the interest and principal at the end of the term to your bank account. Normally, the auto renew feature isn’t too bad but if your CD has an early withdrawal penalty that eats into your principal like the example earlier in the piece, beware!
A Common and Sensible Approach with CDs – Laddering
Many banks offer a higher yield with longer term CDs, so how do you take advantage of this while still having the flexibility of your money maturing periodically? The answer is creating a CD ladder.
Let’s say that the interest rate of the 5 year CD is highest, so in order to take advantage of this, you would divide your month into 5 and open 5 CDs (one that matures in 1 year, another in 2, and so on). Come year 1 when the first CD matures, you will then put that into a 5 year term, and again the same thing when the 2-year CD matures. If you do the same thing for the first four years, you will end up with a 5 x 5-year CDs that matures every year. This way, you can always take advantage of the highest rate while having some money avaialble.
This is a widely popular strategy and one which I highly recommend. Just make sure that you are on top of the maturity dates and so that you aren’t caught off guard.
CDs have a Place for Everyone
Some people believe that CDs are only for the most risk adverse investors, but it actually has a place in everyone’s portfolio!
The high flexible and low risks means that everyone should take a serious look of adding a few certificate of desposits into their overall investment portfolio.